Generate extra cash flow in your portfolio with Covered Calls

Covered Calls offer a great way for investors to generate extra cash flow in their portfolios. Previously, the only cash flow in a portfolio would have been in the form of dividends or interest payments. Covered Calls have become one of the most commonly used and simplest cash-generating option strategies.

A Covered Call is an option strategy where you sell call options over shares you own. The buyer of a call option then has the right, but not the obligation, to buy shares at a specified price on a specific date in the future. For example, if we are the buyer and you are the seller, you will have an obligation to deliver your shares to us at the Covered Calls strike price. You get to choose the strike price at the time the covered calls are traded.

Are Covered Calls right for you?

A Covered Call strategy is something you may consider if you hold shares in a company and:

would like to generate extra yield or cash flow your portfolio;

have a neutral view on the share; and

are willing to sell your shares at your chosen share price or give up any upside above that price

In return for foregoing potential upside in your shares, you’ll receive cash in the form of option premium. While you hold your shares, you will still receive all dividends that the underlying share pays.

We have put together a real life example of an investor (we’ll call him John for the example) who traded Covered Calls over his Standard Bank shares.

Illustration:

John started trading Covered Calls in November 2016, he held 1500 Standard Bank shares (“SBK”) in his portfolio at Online Share Trading. The market had been moving sideways for most of 2016 and he believed that SBK was not about to break out of its trading range in the short term. You could say he had and still has a neutral view on the share, he didn’t want to sell his shares in November 2016 at R151, but he would have been happy to sell his SBK shares if they reached R160.

On the 30th November 2016 John decided to sell Covered Calls over his SBK shares in return for option premium (cash), essentially boosting the income he generates from his SBK shares. At the time he decided to write Covered Calls, SBK was trading at R151, he didn’t think SBK would go much higher than R160 in the short term, so he decided to write Covered calls with a strike price of R160 expiring on the 15th March 2017 (105 days away at the time).

He received R7.05 per share, a total of R10,575 (1,500 * R7.05).

What happens for the duration of the Covered Call trade?

The option premium remains John’s regardless of what happens in the future, he can withdraw the cash or use it to buy more shares

John still receives all his dividends that the SBK pays

John cannot sell his SBK shares while he has a SBK Covered Call position open

What happens on the 15th March 2017 when John’s Covered Calls expire?

If SBK shares close above R160 (John’s chosen strike price), he will deliver (sell) his shares to the bank at R160 per share

If SBK shares close at or below R160, John keeps his shares and he could sell more Covered Calls to the next expiry and take in more premium, this process can be repeated as many times as he wants

On the 2nd March 2017, Standard Bank’s results were announced and the SBK share price rallied more than 5% to roughly R152.50. John decided he wanted to write more calls and earn more option premium.

For every Covered Call you sell you need to hold the underlying share. The only way John could write more Covered Calls would be to either wait until the expiry date of 15th March 2017, or unwind (buy back) his existing Covered Call position.

He chose to roll his Covered Call position by buying back his existing position (costing R1.09 per Covered Call at the time) and selling Covered Calls with a longer dated expiry. He also decided to sell new Covered Calls with a strike price of R160 (same as before but he could have chosen any strike price) expiring on the 29th November 2017 (272 days away at the time) for which he received R11.30 per share in option premium.

John had to pay R1.09 per Covered Call to unwind and received a premium of R11.30 per Covered Call for writing new Covered Calls, which resulted in him receiving a net option premium of R10.21, a total of R15,315 (1,500 * R10.21) as a result of him rolling his Covered Call position. John will also be due to receive dividends on his SBK shares on 3rd April 2017 and then later in the year in September 2017.

John’s cash flow summary from November 2016 to November 2017:

Option Premium (11% yield)

30 November 2017 R10,575

2 March 2017 R15,31

Net Dividends (4.3% dividend yield)

3 April 2017 R5,280

September 2017 R4,704 (Based on Bloomberg estimates)

Total Cash received (15.3%) R35,874

With dividends alone, John would earn a dividend yield of roughly 4.3%, but by using a Covered Call trading strategy he’s managed to boost his income stream to over 15%.